Topic 5 - Investment Criteria Flashcards
(10 cards)
What is the goal of Financial management
To maximise shareholder value
What should an ideal Investment Criteria do (x5)
- Consider all the cash flows of the investment
- Consider the time value of money
- Adjust for risk
- Provide a ranking of projects
- Indicate the added value to the company
What 3 Key Investment Criteria do we consider
- Net present value
- The payback rule
- The internal rate of return
What is the Net present value (NPV)
NPV is the present value of all cash flows from an investment minus the initial cost of the investment
What is the discount rate r
The discount rate is the opportunity cost of capital
What is the NPV formula
NPV = C0 + C1/(1+r) + C2/(1+r)^2 + C3/(1+r)^3 + … Cn/(1+r)^n
What is the Payback rule
Calculates how long it takes to recover the initial cost of an investment by subtracting estimated future cash flows one by one until the cost is repaid
What are the Pros and Cons of the Payback rule
Pros:
- Simple to calculate
- Easy to understand
Cons:
- Ignores the time value of money
- Doesn’t adjust for risk
- Doesn’t show value added
- Biased against long-term projects
What is the Internal Rate of Return (IRR)
The internal rate of return (IRR) is the discount rate that makes the NPV = 0
NPV = C0 + C1/(1+r) + C2/(1+r)^2 + C3/(1+r)^3 + … = 0
What are the cons of the Internal rate of return (x4)
- Multiple IRR’s - if cash flows change signs more than once, the IRR equation can have more than one solution (unclear which one is correct)
- Misleading decisions - IRR may suggest accepting a project when NPV disagrees, NPV should be trusted, directly measures value added
- Assumes reinvestment - IRR assumes all cash flows are reinvested at the IRR itself, unrealistic, especially for high IRR’s
- Scale and timing ignored
